European Central Bank: Monetary Policy and Inflation
The European Central Bank (ECB) and the European System of Central Banks (ESCB)
The European Central Bank (ECB) was established in 1998, according to the Treaty on European Union, to support the euro. The ECB and the national central banks of EU member countries form the European System of Central Banks (ESCB), led by the ECB itself. Its guiding function is to define and implement the single monetary policy in countries that have adopted the euro as their currency. All countries of the European Union are in the ESCB, but countries that do not have the euro cannot direct the monetary policy of the European Monetary Union. In exchange, they direct the monetary policy of their own countries.
Functions of the ESCB
- Define and implement monetary policy in the Eurozone.
- Conduct foreign exchange operations.
- Hold and manage the official foreign reserves of participating member states.
- Ensure a well-functioning payment system in the Eurozone.
- Contribute to banking supervision and the stability of the financial system.
- Authorize central banks to issue banknotes.
Monetary Policy
Monetary policy is the set of actions undertaken by monetary authorities to monitor changes in the amount of money and interest rates. Its macroeconomic goals are increasing GDP growth, increasing employment, price stability, and balance in the external sector. Although most countries pursue the same ultimate goals, following a different order of priority, the most important from the monetary point of view is the control of inflation, or price stability.
Instruments of Economic Policy
- Open Market Operations: The central bank buys or sells public debt to banks. This is currently the most important instrument.
- Reserve Requirements: In most countries, banks are required to maintain reserves at the central bank, a certain function of the volume of deposits.
- Standing Credit Facilities: These are instruments based on special interest rates for entities operating with the Eurosystem under certain conditions. Their objective is to provide and absorb daily liquidity.
Theories of Inflation
- Demand-Pull Inflation: Inflation appears due to an excess demand for goods and services. (Classical school, Keynesian school, and Monetarist school).
- Cost-Push Inflation: The cause of inflation is a sustained increase in the costs of production for companies. When prices soar, factors become more expensive, making production more expensive. If not offset by productivity gains, the ultimate effect will be rising prices.
- Structural Inflation: The reason for inflation is the country’s economic structure and the malfunctioning of its institutions.
Effects of Inflation
- Loss of purchasing power.
- Loss of competitiveness abroad.
- Substitution of national production.
- Increased indirect fiscal pressure.
- Creation of a climate of uncertainty.
The Consumer Price Index (CPI)
The CPI and the household budget: If, for example, the index is now 3% higher than a year ago, it indicates that to buy the same items of consumption today, you need to spend 3% more money. Therefore, in order not to become impoverished, you need to earn 3% more than you did last year. Hence, the CPI is an index used in the application of wage agreements, housing income, pension policies, and, in general, in any private or public transaction where maintaining the level of prices is important.
The CPI is an indicator or statistical variable that allows us to know how much the price of all consumption items that constitute the family basket has become more expensive or cheaper over time. The CPI includes food, transport, education, clothing, etc.